Trichet's misread monetary union

The ECB President, who calls for a 'quantum leap' the way the eurozone is governed, says outsiders misunderstand the Union and the forces that bind it together.

FT.com

Does the world "get” the eurozone? Not in the opinion of Jean-Claude Trichet. True, Europe’s monetary union has appeared on the brink of collapse at times this year as the turmoil created by Greece’s spiralling public sector debt escalated into full-blown crisis. The continent’s political leaders seemed incapable initially of an effective response; talk of a break-up of the 16-country bloc gathered momentum.

Yet the European Central Bank president sees it differently. "I don’t think that the euro area was close to disaster at all – seen from inside,” he says. "I know how Europe functions ... It’s always difficult for external observers to judge and analyse correctly the capacity of Europe to face up to exceptional difficulties.”

It is a striking remark. During the past three years the ECB has had to act as a bulwark to protect the eurozone and its financial system from successive global economic crises. It flooded financial markets with liquidity and lobbied ferociously behind the scenes for an effective response by politicians.

These are still exceptional times for the erudite French technocrat who heads the Frankfurt-based ECB. Financial market worries about countries such as Ireland and Greece have re-erupted; almost two years to the date since the collapse of Lehman Brothers and the safety of the global banking system is still uncertain.

Trichet does not shy away from proposing a potentially controversial "quantum leap” in the way the eurozone is governed in the future – which could see underperforming members stripped of voting rights. Nor is he afraid to draw controversial global policy lessons. This summer, he has been vocal in urging governments to implement fiscal austerity – not fresh stimulus measures.

On the subject of the ECB’s home patch, meanwhile, Trichet argues that outsiders – traders in financial markets in London or New York, say – have misunderstood the eurozone and the forces that bind together the monetary union.

With the ghost of Lehman still in the room, this weekend he chairs a much anticipated meeting of financial supervisors in Basel, Switzerland, to agree a global overhaul of rules on bank capital – dubbed Basel III – intended to prevent future crises. Senior bankers well beyond Europe will on Sunday be anxiously awaiting his words.

He invites his interviewers to conduct a "thought experiment” and imagine if someone had argued immediately after currency turmoil hit Europe in the early 1990s that the single currency would be launched on time in January 1999. Not only that: by 2010 it would cover 16 countries and have delivered an inflation rate averaging 1.97 per cent, "better than that obtained in the previous 50 years under major currencies before the euro”.

It helped that inflation was negative for five months of last year. But in describing the scenario, an animated Trichet exclaims: "That would certainly have been considered much too bold, much too optimistic, perhaps totally unrealistic – but that is what we’ve been doing.”

In May this year, as financial markets feared Greece would default – and maybe Spain or Portugal as well – European Union leaders assembled a €750 billion rescue plan. The ECB threw aside past objections and started intervening to buy up the government bonds of those countries worst hit by the turmoil. So far, it has spent more than €61bn.

The result, Trichet argues, was a surprising demonstration of how a monetary union made up of markedly different governments and political systems – ranging from the economic big-hitters of Germany and France to tiny Mediterranean islands such as Cyprus and Malta – can still function. "There is no other model to which we can refer – either in history or in a fully fledged political federation such as the US ... But I’m always confident. In May we had additional proof of the capacity of Europe to cope.”

The tone is not arrogant. He makes clear the exceptionally testing environment for today’s central bankers, among whom he is the doyen. The advance of science and technology is "developing so rapidly that it creates for the central bankers a lot of additional challenges, in particular in terms of assessing correctly productivity”, he says. The ECB has also to drive Europe’s economic integration and oversee the eurozone’s expansion.

The continuing financial turmoil simply adds layers of complexity. "We are in a situation where central banks in particular, and also other authorities, have to remain alert and have to know that we are in an uncertain universe. We always have to be prepared for new challenges that cannot necessarily be foreseen . . . We have to be in a state that I call ‘credible alertness’.”

Notwithstanding the difficulties and a gruelling global schedule, the silver-haired Trichet, aged 67, has thrived as a Frankfurt-based central banker – his compatriots complain that in his monetary rigour he has become "more German than the Germans”. He has handled international crises since the mid-1980s when, as a French treasury official, he chaired the "Paris club” of creditor nations and was closely involved in debt problems that struck Latin America, Africa and the Middle East.

He was on the front line during the 1990s crisis in the European exchange rate mechanism – the forerunner of monetary union – and was governor of the Banque de France when the September 11 2001 terror attacks on the US required monetary authorities hurriedly to ensure the security of the global financial system.

That long experience has made Trichet a pragmatist, steeped in the lessons of history rather than academic theory. Thus he had no hesitation in taking bold measures during the past three years. But the man who travelled to Berlin in April to persuade German parliamentarians to back a rescue plan for Greece warns that policymakers may simply not be able to take the same steps again.

This weekend’s Basel III negotiations are part of global efforts to put banks on a surer footing. Some argue that the proposals have already been watered down as a result of lobbying by the banks. Trichet will not comment in detail but is adamant on one point: "We cannot again ... be put in a situation where the financial sector is about to collapse.”

On both sides of the Atlantic, governments had to put up taxpayer funds equivalent to 27 per cent of gross domestic product in rescue packages and guarantees. "We cannot do that twice. The people in our democracies would not accept that.”

The rules, when they are agreed, will have to be implemented globally, he insists. "One of the major structural transformations of global governance over the last three years”, he says, has been the rising influence of emerging market economies. Summits of the Group of 20 nations, which includes Brazil, India and China, have supplanted the older G7 formation of western industrial powers, he argues. "That is something which I would call a silent revolution in global governance.”

Within the eurozone, serious weaknesses remain. Trichet dismisses the threat of deflation – persistent and general falls in prices – arguing that consumer and financial markets’ expectations about future inflation rates are in line with the ECB’s target of an annual rate "below but close” to 2 per cent. He is also sanguine about the prospect of a US slowdown hitting the eurozone’s export-led recovery. On the other side of the Atlantic, "there is a mood which seems to me too negative”, he says. "That’s my own personal feeling.”

But the ECB president is frank in arguing that Europe should have been quicker in following the US in conducting bank "stress tests” and publishing the results. The step was taken only in July. "We have a very complex institutional environment, involving co-operation in real time among 27 EU capitals,” he says. "It was really essential to have this exercise undertaken on a unified basis, simultaneously.”

The ECB has kept largely in place the exceptional measures introduced after the Lehman collapse to prop up the eurozone banking system. With banks in countries such as Greece, Portugal, Ireland and Spain still dependent on unlimited ECB liquidity, Trichet said last week that banks’ demands for weekly, monthly and three-monthly funds would be met in full until at least early 2011.

The ECB president still insists that the central bank has embarked on a "progressive phasing out” of those measures. Offers of 12-month and six-month liquidity have been dropped. But he acknowledges implicitly that the exit strategy will be long and drawn-out: "We are accompanying the market as it progressively goes back to normal.”

Trichet is in the meantime pushing hard for political reform of the eurozone. On such issues, the ECB president also feels vindicated. When France and Germany argued in 2004 and 2005 for a weakening of Europe’s "stability and growth pact”, which sets rules including debt and deficit ceilings for eurozone members, the ECB had made clear its opposition to changing the accord. "It was a very, very fierce battle.” He adds: "They wanted to destroy it.”

Today, he wants a "quantum leap” forward in eurozone governance. In the coming weeks, Herman Van Rompuy, the EU’s president, will set out possible ways forward. Trichet wants sanctions imposed "quasi- automatically” – in other words, judged according to objective criteria – on members that flout fiscal rules in future. There should also be toughened monitoring of member economies’ competitiveness. His preference would be to change EU treaties accordingly. In practice, garnering the necessary national support would be politically impossible. So Trichet argues for using existing laws to the maximum.

He could have a fight on his hands. It is unclear whether such a sanction would be legally possible. Some politicians would see the idea of a recalcitrant eurozone country being left out of decision-making as an unacceptable dilution of sovereignty.

That does not stop him offering controversial proposals. The ECB opposes the idea of a eurozone member ever being ejected – even the theoretical possibility would encourage damaging speculation in the financial markets. But Trichet says the temporary suspension of voting rights "is something that should be explored”.

The fact that Trichet is even able to suggest such an idea shows the status acquired by the world’s independent central bankers. But for the forthright Trichet, whose non-renewable eight-year term expires in less than 14 months, the principle of central bank independence – when politicians face tough decisions – has more than stood the test of time.

As he puts it, in falsely modest central bank-ese: "The concept of independent central banks having a stake in stability, and a medium to long-term perspective, has been recognised as the right concept.”

Copyright The Financial Times Limited 2010.

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